Does government interference help in financial crises?
Despite their best intentions governments rarely - if ever - solve financial crises
Which single aspect of the complex mess of financial and economic crises supposedly coming to a head is absolutely certain? The answer is that governments will not solve these problems. They never do. At best, palliatives will be devised, interim solutions found and some of the worst consequences of fiscal default, or similar, will be avoided.
Yet when European leaders battle over how to settle their budgetary problems, they claim to be moving towards a solution that goes further than short-term measures. The same is said about their efforts to "save" countries like Greece and Spain.
Meanwhile in the US, legislators and the President are playing an elaborate game of brinksmanship to prevent the nation toppling over the so-called "fiscal cliff".
At best, there will be a last-minute deal in which politicians trade concessions with each other and the US Treasury lives to see another day, or at least, the next crisis.
In both Europe and the US, the focus on tackling fiscal problems is plagued by an enormous degree of fetishism about debt. Take the example of Britain, struggling to recover from recession. There, the government relentlessly talks about debt, while setting aside other issues. Yet British public debt remains at levels lower than that which prevailed for most of the past century.
Moreover, as US economist Paul Krugman has pointed out, "Debt is one person's liability and another person's asset." Crises emerge when everyone is forced to pay off their debts at the same time, which is around the time that people start worrying about the biggest holders of debt: the banks. Banks and other financial institutions have become increasingly reckless in the manner by which they acquire assets, also known as debts, and this makes them more vulnerable to collapse when markets lose confidence in the worth of these assets. This is what happened in the big crisis of 2008, and it's what has happened before.
American legislators thought they could forestall this by passing the Dodd-Frank Act in 2010. This contains a staggering 2,319 pages of legislation designed to ensure that the US will never again face the problem of "too big to fail" banks. It is also meant to prevent other major financial institutions following Lehman Brothers into collapse.
So it's fair to ask: have banks become more manageable in size? Have they become less greedy? And are they becoming more risk averse? The answer to the first question is clearly no. Bank of America's assets, for example, have grown from US$1.8 trillion to more than US$2.2 trillion. Banks got a bit more cautious, but look at how J.P. Morgan in July incurred a US$6 billion trading loss that it more or less shrugged off.
As for the matter of greed - that's subjective, but it remains hard to find bank customers who do not believe their banks are greedy.
Although it was a massive piece of legislation, the Dodd-Frank Act is relatively focused compared with one of the biggest ever interventions in the US economy - the New Deal policies of President Franklin Roosevelt designed to lift America out of the severe economic depression triggered in 1929. The New Deal was a massive make-work programme, accompanied by a host of business creation schemes and legislation to control anti-competitive business activities.
But the US remained stubbornly in recession until it joined the second world war. It is open to question whether, without the national mobilisation that accompanied the war effort, Roosevelt's policies were working. But it is clear that they alleviated some of the more gruelling hardship brought about by the recession.
In pre-war Nazi Germany, there was an even more vigorous anti-recession programme that put people back to work, created a seemingly booming economy, and purported to show what firm government could accomplish. Aside from the monstrous human cost of what happened during these years, economists now believe that much of what was achieved was a mirage that could not have been sustained, and the consequences were masked by the outbreak of war.
Even those who concede the ineffectiveness of ambitious programmes designed to solve financial problems believe that governments can be successful when they are more focused on single goals capable of resolution. In this regard, they sometimes cite the alleged success of the Hong Kong government's attack on what it said was a "double play" by speculators trying to bring down the local stock market and its currency in the wake of the 1997 Asian financial crisis.
The government struck in August 1998 with its famous market intervention, but many people have forgotten that in June of that year, the Tung Chee-hwa administration took the extraordinary decision to freeze all land sales as pressure mounted to halt the rapid slide in property prices. At a stroke, a golden opportunity to do something about Hong Kong's crazy property price situation was sacrificed to placate powerful business interests who saw their assets dwindling in value.
The collapse of Hong Kong share prices was equally acute in other Southeast Asian nations. But in Hong Kong, the government convinced itself that there was something sinister about this, and saw that punters were also gambling on the fall of the local currency. So the government plunged into the market, buying Hong Kong dollars and snapping up almost 10 per cent of the blue chip shares in the market. This massive market raid was declared to be a great success, but not a shred of evidence was produced to confirm the existence of this alleged concerted attack. Moreover, the buying spree left an enormous overhang of illiquidity in the market.
And in a couple of days, it became clear that a lot of the hot money would have left anyway, as big players needed to cover their positions in the Russian government debt market, which was threatened with default. Thanks to the government, these players managed to get out of the Hong Kong market with a great deal more cash in their hands.
The final test of whether this government intervention worked can be gained by comparing what happened in Hong Kong to what happened elsewhere, in places like Singapore and South Korea, which were equally exposed to these international market forces.
They desisted from massive market intervention, yet managed to emerge from this crisis at more or less the same pace as both Hong Kong and Malaysia, which engaged in a similar level of frenzied market intervention.
The lesson is that most crises sort themselves out as the economic cycle turns and turns again. It is quite true that while these crises are under way, enormous damage can be inflicted, and that this can be alleviated or deepened by government action. But governments do not provide fundamental solutions.
Moreover, it is only by understanding the roots of these crises that it's possible to appreciate why. Crises do not arise because demand for goods and services suddenly grinds to a halt. The real problems lurk within financial markets, and, contrary to current popular belief, it is not public debt that lies at the heart of the problem, but private sector credit.
This, at any rate, is the conclusion drawn by Alan Taylor in research for the US-based National Bureau of Economic Research. He looked at the causes of financial crises from 1870 to 2008 in 14 major economies, and established a link between financial crises and the growth of private sector credit.
The problems were aggravated by a concurrent growth of public sector debt. This research shows how unsustainable credit expansion finally collapses, and leads to a crash because neither the private sector nor government has the means to meet all liabilities as loans are suddenly called in.
The problem then becomes compounded because mistrust in the system, and the ability of debtors to honour their commitments, leads to a vicious circle of perceptions creating a reality that, in turn, produces new problems arising from that reality. Governments tend to further aggravate the situation by retrenching and adopting austerity measures that prolong the recession. A classic example of this is seen today in Britain, but not in the US, where a different approach has led Americans out of the recession more rapidly.
Ultimately, demand will return to the private sector, not least because it is pent-up and supplies have been exhausted. At this point, the crucial factor is whether or not the private sector can meet this demand. Governments can help here by adopting monetary policies that encourage lending and making it less expensive, but again, this is intervention on the sidelines, and does not occur at the heart of the matter.
Keynesian economists believe that the return to consumption can be brought forward, and even sustained by government action. But as the New Deal showed, it is very hard to make this work. Yet it is the role of government to restore confidence and to devise policies ensuring that when the business cycle is ready to turn around, there are no obstacles to renewed growth.
Some people in Hong Kong feel rather smug about having a government that runs impressive budget surpluses and only seems to raise public debt to nurture the local bond market.
But as the events of 1998 showed, this remains a vulnerable economy operating under an administration with panicky instincts. It talks big about laissez-faire, but in practice likes to meddle, as the recent foray into property market controls again demonstrated. This intervention has produced many related problems, so it cannot be hailed as a success.